S&P Downgrade a Harbinger of Changing Times

Standard & Poor’s downgrade of the United States Treasury Department is a harbinger of changing times. The institutional mind has been trained to operate within the framework of the Capital Asset Pricing Model (CAPM). The CAPM is a formula, designed by professors, that assigns assets to distinct and simple categories. It filled a need when the investment management industry drew in the masses. Not, in this case, the mass of investors, but the mass of so-called investment professionals, that include consultants to pension plans, endowments, and foundations. Most of the well-compensated consultants have little understanding of investing, so substitute vocabulary for thought. The same is true of the professors who hand each other Nobel Prizes and collect seven-figure consulting fees for pontificating.

In the October 2002, issue of Marc Faber’s Gloom, Boom and Doom Report, I wrote an essay about the Capital Asset Pricing Model and its companions (e.g., efficient markets), that doused the homogenized investment industry which had contributed to the then-current consequence (in October 2002) of a runaway housing mania. Quoting from that 9,000-word dirge: “Indexing is an obvious conclusion to efficient markets. Since companies do not matter, the asset class is all. Indexes are also practical. We all have some idea of what’s going on today when we hear that the Dow is down 200 points. From that rudimentary average have been added the Standard & Poor’s 500, the Russell 1000, 2000, and 3000. Dozens of offspring met the demand for ever more microscopically defined asset classes that fill the mauve, turquoise, and magenta slices of the consultants’ pie charts.”

The CAPM includes a “risk-free rate of return.” The risk-free asset is, in its simple form, a United States Treasury bill, which has more recently been noted for its “return-free risk.” Both in theory and in fact, Standard & Poor’s downgrade of the United States from AAA to AA+ is another death rattle for the CAPM. (The downgrade itself has little real meaning, aside from its influence on minds.) This action foreshadows the declassification of assets according to such dreary concoctions as “mid-cap growth,” comparative asset benchmarks, and the hierarchy of asset classes that equate higher return with higher risk (e.g., cash, bonds, stocks).

There is also the much larger problem of constructing an asset pecking order with rigged asset returns and yields. The market rate for Treasury bills is not zero. The coming dislocation that institutional and retail investors face is, to most if not all, incomprehensible. Consider the reconstruction of Scarlet O’Hara’s Capital Asset Pricing Model after 1860. She discovered what can happen to chimerical fortunes built on the backs of government-fixed, zero-percent, risk-free rates.

The authorized hierarchy is a reason that Treasury yields fell after Timothy Geithner was downgraded on August 5, 2011. Europeans peering over the precipice owe professors and the (so-called) investment professionals – in reality, they are all a bunch of bureaucrats – a kick in the behind for their simplifications. European banks are not required to allocate tier 1 capital against government bonds since sovereign debt is risk-free. So, they bought like there was no tomorrow. Tomorrow has arrived and European banks are furiously ridding themselves of Greek, Portuguese, Italian, French – and anything else that isn’t German – sovereign bonds (so, risk-free!!!) that have left them on (or over) the brink of insolvency.

The classification game is finished. In these waning hours of western civilization, gold is safer than government bonds. It also has much higher return possibilities than the unlimited supply of 0.001%, 10-year Geithners – take that, CAPM! Many institutions will sink, including governments. Sovereignty is not what it used to be. Some of the universities where highly decorated professors teach will cease to exist. This is a deleveraging world. It does not conform to the categories. Periodic bursts of insight, such as market behavior of the past two weeks, are preceded by months of mental hibernation.

Looking at that October 2002 diatribe in the Gloom, Boom and Doom Report, probably for the first time since I wrote it, brings to mind all the frauds – central, commercial, and investment bankers, in particular – who claim: “We never saw it coming.” The two most recent Federal Reserve Chairmen, Greenspan and Bernanke, have most adamantly insisted, during sworn testimony, that not only did they not see “it” coming, but also, that nobody – yes, nobody – could have seen the credit bubble before it burst.

There were many readers of the October, 2002 issue of the Gloom, Boom, and Doom Report who had already identified the housing bubble. Telephone calls and emails came from all points of the compass. They saw it coming in Hong Kong, London and Madrid, but not at the Fed. Quoting myself from the 2002 essay (this is inevitably an instance of self-promotion, but, inseparable from another attempt to expose these mental and moral midgets):

“Most people who have seen the Internet bubble inflate and burst, who have seen the Nasdaq bubble inflate and burst, do not recognize, even though similar characteristics and atmosphere surround them, that the U.S. real estate market is a credit bubble (of which the stock market bubble was a sibling) and it is living on borrowed time.”

“America is broke. We could really stop right here. For an investor, a helpful rule-of-thumb is to own real money (cash, gold, a company trading at its cash value) and squeeze debt-dependent conglomerations until they gag and choke.”

I wrote several pages about the then – October, 2002 – obvious housing and credit bubble. Following is one paragraph:

“There never has been a time, since World War II, when homeowners have held less equity in their residences than they do today (about 55%). Is ‘homeowner’ a dated description? There is an incredibly well tuned mechanism at work here. The savings rate of individuals fell to zero a couple of years back. The ready reason was the stock market — who needed to save? That money lost, the Average Joe tapped his home equity line. This is unfortunate; a chance to regain his financial solvency is lost. As Nicholas Retsinas of the Center of Housing Studies at Harvard noted, “With real-estate prices up, you would think that Americans would be rolling in home equity. But as fast as they lay hands on it, they are borrowing it out.” Not only is this a source of credit, but also the interest rate structure is so low and the borrowing terms so aggressively profligate (loans of 120% of appraised value are hot, Fannie Mae and Wells Fargo have restrained themselves at 107%, interest-only loans for the first 15 years are a big hit) and so flagrantly unscrupulous (the Philadelphia Inquirer reported of brokers tracking down more aggressive appraisers) that the village idiot is living a very princely existence. (Need it be said that buying on infinite margin, house prices have risen according to a structure that might be called the home carry-trade?)”

I was already trying to expose the most destructive American who has ever lived. An effort, I might add, that was a waste of time:

“Greenspan is still talking about the New Era producing miraculous leaps in the timeliness of information, yet he couldn’t tell there was a bubble when the Nasdaq traded at a 400:1 price-to-earnings multiple.”

“‘What Greenspan says is what the market does.’ That eight-word proposition that so many believed was all they cared to know. Now, a growing number have second thoughts. This may have been what prompted him to deliver what has become known as his “Jackson Hole Speech” on August 30 [2002]. He claims there is no way he could have seen a bubble coming, seen it when it was here, or done anything about it even if it cuddled up beside him and offered to buy lunch. He claims he couldn’t have known about a bubble since that knowledge is available ‘only in history books and musty archives.’ What are we to make of that? Maybe, bred in a republic, he is confused about his [then recent] British knighthood and thinks it requires him to play the role of court jester. Why hasn’t some politician grilled him, at least to evaluate his mental faculties? Maybe they fear the precarious financial state of the union is positively correlated to our confidence in the head of the Fed. To rant now may cause real capitulation and a liquidation of over leveraged and non-performing assets. (Compared to a shoe factory, a new 6,000-square-foot house is not all that productive. It is an asset that fills up previously empty air.)”

Even in 2002, the Most Destructive American – who still appears on the Sunday-morning talk shows, still enjoys periodic love-ins with Maria on CNBC (subsidiary network to NBC, where Greenspan’s wife pulls strings), continues to write tripe in the Financial Times, has read (so-called) academic papers (thus validating his importance) at the Brookings Institute and Counsel of Foreign Relations – was working hand-in-hand with the housing industry:

“In other words, chaotic lending and borrowing reigns, although few see it as such. We have it on the authority of David Seiders, Chief Economist of the National Association of Home Builders, whose stentorian late-July blast comforted the wary: ‘The time has come to put this issue to rest. The nations [sic] home builders have said it, the [r]ealtors have said it, and Alan Greenspan has said it once again, in no uncertain terms: there is no such thing as a current or impending house price bubble.'” It is an odd feeling to correct my grammar nine years later. Why didn’t you catch that, Andrea? (Andrea was my top-notch assistant who proofread countless tirades against empty suits and on behalf of gold. If you are looking for someone with such talents, please let me know. )

The following two extracts are a warning of how faith-based investors continue to think today:

“[Greenspan] sought… adulation like the celebrities who grace the covers of People magazine. He filled the role of fashion model to perfection. He was known for what he was rather than what he did. He was the man who forever moaned incantations to the New Era and New Economy, and he drew legions of followers, agape as we were to this new technology, of which we did not understand the actual importance, but he unfailingly did.”

“[Greenspan] met a willing audience, one that was quite content to believe his testimony even though his speeches were nearly impossible to understand, even by the most astute Fed watchers. He speaks in hieroglyphic abstractions. Common sense should have told his legions of admirers to act prudently, but that was not the mood of times. As Samuel Johnson reflected, ‘In time some particular train of ideas fixes the attention, all other intellectual gratifications are rejected, the mind, in weariness or leisure, recurs constantly to the favorite conception, and feasts on the luscious falsehood whenever she is offended with the bitterness of the truth.'”

Mr. Sheehan was Director of Asset Allocation Services at John Hancock Financial Services in Boston. In this capacity, he set investment policy and asset allocation for institutional pension plans. For more than a decade, Mr. Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for clients.

He is a frequent contributor to Marc Faber's "Gloom, Boom & Doom Report." He also has written articles for "Whiskey & Gunpowder" and the Prudent Bear website, among others. He currently serves as an advisor to an investment firm and a non-profit foundation.

A Chartered Financial Analyst, Mr. Sheehan is a graduate of Columbia Business School.